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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era -- Ignore unavailable to you. Want to Upgrade?

To: Daniel Chisholm who wrote (180)	4/17/1998 3:25:00 PM
From: Reginald Middleton	Read Replies (2) \| Respond to of 1722

Let me clarify a few things. I try not to refer to use the term EVA, for EVA is a trademarked moniker of a potential competitor. Economic value added is actually a periodic method of DCF (discounted cash flow), otherwise known as economic profit. <My thumbnail sketch of his EVA model is that he considered all the different sources of a company's capital (debt, common, etc), and assigned a "cost of capital" to each class. Obviously for the debt part this is easy, it's just the interest rate that you have to pay. For the equity part he assigned a number like 12%.> The cost of capital for debt is arrived at by taking the current rate and subtracting the benefit of any tax shields that may apply. This converts the rate into an actual risk adjusted cash cost for the company in question. <The thing that bothered me was the a priori choice of a cost of equity capital of 12%. I believe the rationale for this is that this is an historic return required for equity capital. Though this is at least a rational rationale, I had (and have) some doubts about using an historical cost of equity (derived from all equity investments). My concern was that this would set excessively high or low hurdles for management, since it did not take into account the riskiness of their industries, etc.> A base return requirement, the historical equity risk premium over long term riskless securities for the equity market is used as a start (I use 5.85% which encompasses the entire history of the equity market, spanning two market crashes, several recessions, many booms and busts and no less than 5 (or 4?) wars. This is then adjusted by the risk specific to the individual company or corporate division. A combination of deleveraged beta and business risk is used to determine this figure. When added together, you get the adjusted risk premium for the entity in question. It is important to include all capital in your analysis and not just equity capital to ensure that the company is using it's entire capital base efficiently(inefficiently), and not just equity. For instance, the ROE could be 20%, but the return on total capital could be atrocious, in which case there is a significant problem. This is usually the case in highly leveraged companies, whose leveraged was put in place by financial buyers who wish to artificially boost the ROE at the expense of the rest of the investors/capital base.